Blaming it all on QE2

In Thursday’s (October 13, 2011) Financial Times, Tim Bond, investment strategist at Odey Asset Management, wrote a column welcoming “a world without QE.” Acknowledging that equity markets around the world were disappointed by the failure of the Fed to restore a program of monetary easing, some form of QE3, Mr. Bond contends that the reaction was “myopic and mistaken,” calling QE2 “a mistake with problematic unintended consequences.” He explains:

The underlying defect in QE is that it stirred investors’ fears of monetary inflation, whilst stimulating the wrong sort of inflation in the wrong places. The early positive economic effects were subsequently overwhelmed by a negative inflationary blowback that played a key role in disrupting the recovery.

This is a rather different take from mine, which is that investors don’t fear inflation, they yearn for it, as evidenced by the strikingly positive correlation, since spring 2008, shortly after the downturn starting the previous December, between changes in the TIPS breakeven spread and changes in the S&P 500 . (I have presented evidence for this correlation, based on data through the end of 2010, in my paper “The Fisher Effect Under Deflationary Expectations” available here, and I explained why the stock market loves inflation in this posting.)

Intimating that the rise in commodity prices prompted by the QE2-induced expectation of rising inflation took everyone, especially policy makers, by surprise, Mr. Bond observes that “fears (my italics) of monetary inflation prompted a widespread portfolio reallocation into commodities.” However, a portfolio reallocation from holding cash to holding physical capital is a key element of a recovery from a sharp downturn such as we experienced in 2008, expectations of increasing returns from holding capital assets relative to returns from holding cash spurring investments in working capital (i.e., inventories, including raw materials, intermediate goods, and final goods) and in fixed capital (machines and structures). Why this salutary reallocation constitutes “negative blowback” is not explained, Mr. Bond apparently considering the adverse nature of any increase in commodity prices too obvious to require any elucidation on his part.

But the “more important flaw in QE,” according to Mr. Bond,was that it “stimulated large financial flows into China and other emerging market (EM) economies, as investors sought a higher-yielding, hard currency alternative to the dollar.” These hot money flows fueled an unwanted credit expansion in China, triggering a sharp rise in inflation and a real-estate bubble. Rising inflation in China added to the pressure on commodity prices, boosting global inflation. The increase in global inflation, in Bond’s view, is responsible “for the sharp slowdown in global growth since the start of the year,” presumably because “higher inflation eroded household incomes and demand at a time of very slow nominal income growth.” The credit bubble forced the Chinese authorities to tighten policy, producing a slowdown in Chinese economic growth.

Mr. Bond attributes large recent money flows into China to a desire to avoid a depreciating US dollar. That is a superficial view. Large quantities of dollars have been flowing into China for over a decade, especially from about 2002 to 2007. The primary cause of those dollar flows was a desire by China to accumulate foreign exchange and to promote Chinese exports (the two are closely related and it is not clear which desire is the more fundamental) by limiting the increase in Chinese consumption. Criticism of China’s exchange-rate policy of pegging the yuan exchange rate against the dollar mistakenly focuses on the fixed nominal exchange rate between the yuan and the dollar. That focus is misguided. A fixed nominal exchange rate did not force China to limit the growth of Chinese consumer demand and to accumulate huge hoards of foreign exchange. A more balanced Chinese monetary policy than that which has been followed (though the policy seems to have been moderated in the last couple of years) would, even with a fixed yuan-dollar exchange rate, have allowed Chinese wages to rise more rapidly than they did, fostering rapid growth in the non-tradable-goods sector in China rather than forcing all the growth into the tradable-goods sector. The rapid increase in Chinese property values, mistakenly called a bubble by Mr. Bond, reflects the underinvestment by the Chinese in their domestic housing stock, not an inflationary real-estate boom, and certainly not a boom fueled by the modest QE2 program pursued by the Fed for only about 8 months. To attribute recent hot money flows from the US to China to an increase in expected US inflation ignores the simple fact that if economic growth and, hence, real interest rates in China are much higher than in the US, cash will be drawn, one way or another, from the US to China pretty much irrespective of what the US rate of inflation is. Even if some of the dollar flow to China is driven by speculation on an appreciation of the yuan, it is hardly clear how much of a role QE2, or QE3 if it were to happen,would play in the decision to raise the value of the yuan.

Mr. Bond confidently posits an almost immediate connection between increased inflation and reduced growth since the start of 2011, but the closest he comes to providing an explanation for this connection, lacking any basis in economic theory detectable by me, is that “higher inflation eroded household incomes and demand at a time of very slow economic growth.” Obviously begging the question of how nominal income is determined, Mr. Bond evidently is suggesting that nominal income is determined by factors independent of monetary policy. But if monetary has no effect on nominal income, the question then presents itself : how is it that QE2 could have caused commodity prices to rise in the first place?

If Mr. Bond is prepared to assert both that QE2 raised commodity prices and that QE2 did not raise nominal income, he is a brave soul indeed. Bravery is undoubtedly a virtue, and compensates for many shortcomings. Defective logic, however, is not one of them. The audacity of confusion has its limits.

George Gilder pointed out that if we choke off the economy in response to higher commodity prices, we also choke off incentives to look for and develop commodity supplies.

Add on, that commodity prices are highly speculative–we should choke off our economy in response to a speculative surge in commodity prices?

Add on that China and India (pop. 3 billion) are printing money and boosting real demand for commodities–not everything that happens globally happens because of DC or London. We choke ourselves while India and China boost commodities prices?

All in all, Tim Bond has constructed some of the weakest reasoning since the French built the Maginot line.

Final add: Japan has de-printed itself down into deflation–and yet commodities kept soaring. They were world’s second largest economy until recently. So, Japan’s deflation did not hold down commodities prices–why should an American deflation hold down commodities prices? Could it be that commodities are a global market?

Oh, you can beat inflation all the time—it just costs more than it is worth to do do.

Marcus, Thanks for the link to your post, which was very informative, as usual. Clearly globalization affects the US and commodity prices are largely determined in world markets, so it is absurd to think that US monetary policy is the only factor affecting those prices.

Lars, I sure hope not.

Benjamin, There was an item which in the Financial Times recently that I meant to flag pointing out that increased prices for grains had caused a major increase in world output despite bad weather in some parts of the world.

“Mr. Bond confidently posits an almost immediate connection between increased inflation and reduced growth since the start of 2011, but the closest he comes to providing an explanation for this connection, lacking any basis in economic theory detectable by me, is that “higher inflation eroded household incomes and demand at a time of very slow economic growth.” Obviously begging the question of how nominal income is determined, Mr. Bond evidently is suggesting that nominal income is determined by factors independent of monetary policy.”

This guy can get published in the Financial Times, but he doesn’t understand that the word “inflation” means rising prices *and* rising wage and income levels? I expect this mistake from most people I talk to (indeed, the argument for a moderate-but-positive inflation rate that was taught to me in college assumed that people view their wages as basically unrelated to price levels, which is the same mistake). But the Financial Times is supposed to be a bastion of cautious reason!

Will, People make this mistake all the time, and it is really annoying. I don’t know why, but everyone seems to assume that inflation affects the prices of everything that they buy but nothing that they sell.

Dear Sir. Thanks for your excellent comments on my article in the FT. You are right in many ways, but let me explain my own perspective. I welcomed QE2 as a logical way of reducing the real value of our massive debt burdens in the west. The subsequent trajectory of the business cycle proved me wrong. Why? Simply put, in a period in which a larger than usual share of income is extracted by the business sector, household income growth has been slow. Business capex/profit ratio is remarkably low, so businesses are not recycling cash into demand. Not surprising given the lack of animal spirits and the lack of trust in external financing markets. The household sector, with wage income running in the 3-4 pct region, can therefore be easily sent into negative consumption territory with a moderate inflationary shock. And let me distinguish between inflation generated by wage/nat income and inflation generated by a supply shock. I welcome wage inflation – which will eventually return due to EM wages and due to social protest in the West – as the final antidote to excessive debt. Inflation due to commodity prices + Chinese growth is not going to help, because the hit to real incomes reduces nominal growth in the west and therefore reduces tax receipts. We need – oddly – a deflationary boom to get the right sort of inflation we need to ease the debt burden. That is where i am at the moment, but i absolutely stand to be corrected. All the best Tim Bond

Tim, It was good of you to take the time to reply to my post about your piece in the Financial Times. I agree that one expected benefit of QE2 was that it would reduce the real burden of household debt, but it was not the only one. Nominal (and real) income growth slowed despite QE2. You seem to attribute the slow down in nominal and real income growth to a rise in commodity prices. My point is that much of the rise in commodity prices was based on an expectation that QE2 would cause nominal and real income to rise. So there is a disconnect between attributing rising commodity prices to QE2 and saying that rising commodity prices stopped the recovery. I think that the explanation lies in bad luck (very severe winter weather in the US, anxiety about oil supplies caused by the Arab spring and the Libyan uprising, the Japanese tsunami and its aftermath, and the failure to contain the euro/debt crisis) not QE2 itself. If QE2 had been more ambitious, it might have overcome those setbacks, but QE2 was too little and too short-lived to its goals in the face of those four nearly simultaneous adverse shocks (3 supply-side and 1 demand-side).

I am not sure what you mean by “wage income running in the 3-4 pct. region,” but I agree that the failure of real income to rise while prices were rising (owing to the series of one-off supply-side shock last winter and early spring) hurt consumer confidence and caused a retrenchment in consumer spending. The objective has to be to increase growth in nominal income enough to achieve a spillover into real income growth. If this happens rising prices will have a positive effect on consumer confidence not a negative effect. Thanks again for your response, David

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.